Professional Documents
Culture Documents
Paper WP817
September, 2009
100 QUESTIONS ON
FINANCE
Pablo Fernndez
Navarra - 1
100 QUESTIONS ON
FINANCE
Pablo Fernndez1
Abstract
This paper contains 100 questions that students, alumni and other persons
(judges, arbitrageurs, clients) have posed to me over the past years.
They were recompiled so as to help the reader remember, clarify and, in
some cases, discuss some useful concepts in finance. Most of the questions
have a clear answer but others can receive several emphases. A short answer
to all of
the questions is provided at the end of the paper.
Introduction
This paper contains 100 questions that students, alumni and other persons
(judges, arbitrageurs, clients) have posed to me over the past years.
They were recompiled so as to help the reader remember, clarify, study in
depth and why not? discuss some useful concepts in finance. Most of
the questions have a clear answer but others can receive several
emphases. A short answer to all of the questions is provided at the end
of the paper.
1. Is the net income of a year the money the company made that
particular year or is it a number whose significance is quite
doubtful?
2. Is depreciation the loss of value of fixed assets?
3. The so-called cash flow (net income plus depreciation) is a flow
of cash, but is it a flow to the shareholders or to the company?
4. The dividend is the part of the net income that the company
distributes
to
shareholders. As the dividend represents real
money, the net income is also real money. Is that true?
5. The part of the net income that is not distributed to shareholders
goes to reserves (shareholders equity). As dividends represent
real money, reserves are also real money. Is that true?
6. Does the shareholders equity represent the savings a company has
accumulated through the years?
7. Is book value the best proxy to the value of the shares?
8. Is a valuation realized by a prestigious investment bank a
scientifically approved
result which any investor could use as a
reference?
9. Is it possible for a company with a positive net income and which
does not distribute dividends to find itself in suspension of
payments?
10. There are four ways a company can use the money it generates: a)
buying other companies or assets; b) reducing its debt; c)
distribute it to shareholders, and d) increasing its cash
holdings. What other reasonable things can it do?
11. Assuming a company wishes to distribute money to its shareholders,
is it better to distribute dividends or to repurchase shares?
12. Is the price of futures the best estimate of the /$ exchange rate?
13. How could we obtain an indisputable discount rate? How should we
calculate the beta and the risk premium?
14. My company paid an extremely high price for the acquisition of
another company; the price was recommended by the valuation of an
investment bank. We now have financial problems. Is there any way
to make that bank legally responsible for this situation?
15. Which currency has to be used in an international acquisition
in order to calculate the flows?
16. Calculated betas provide different information if they are
obtained by using daily, weekly or monthly data. Which data is the
most appropriate?
17. Does is make any sense to calculate betas against local indexes
when a company has a great part of its operations outside this
local market? I have two examples: BBVA and Santander.
18. Is it possible to make money in the stock market when the
quotations are going down? What is credit sale?
19. Which capital structure should we consider when calculating the
WACC for a subsidiary valuation: the one that is reasonable
according to the risk of the subsidiarys business, the average of
the company or the one the subsidiary tolerates/permits?
20. Are there any ways to analyze and value seasonal businesses?
21. A financial consultant obtains different valuations of my company
when it discounts the Free Cash Flow (FCF) as opposed to when it
uses the Equity Cash Flow. Is this correct?
22. Which parameter better measures value creation; the EVA (Economic
Value Added), the economic profit or the CVA (Cash Value Added)?
23. How could we project exchange rates in order to be able to
forecast exchange differences?
24. Is it possible to use a constant WACC in the valuation of a
company with a changing debt?
25. Which method should we use to valuate young companies with high
growth but uncertain futures? Two examples were Boston Chicken
and Telepizza when they began.
26. Which of these two methods is better: discounting the Equity Cash
Flow or discounting the Free Cash Flow?
business?
owner and
them of
an
apprentice.
This
type
of tax
system exempts
65. I have a doubt regarding the Enron case. How could such a
prestigious investment bank advise investing when the quotations
of the shares were falling?
66. Is the following affirmation of an accountancy expert true? The
valuation criterion which reflects the value of the shares of a
company in the most accurate manner is based on the amount of the
shareholders equity of its balance sheet. Stating that the value
of a companys shares equals its book value is a valid
argument.
67. Could we say that goodwill is equivalent to brand value?
68. Could we say that the value of shares is intangible?
69. When calculating the WACC, is the weighting of the debt and the
shares done with book values of debt and shareholders equity or
with market values?
70. The market risk premium is the difference between the historical
return on the stock market and the risk-free rate, for every year.
Why is it negative for some years?
71. Is it correct to use in the valuation of the shares of a company
the value of the real net assets which, according to the
Institute of Accounting and Auditing (ICAC), represents the book
value of shareholders equity, corrected by increases or
decreasing in value which could be demonstrated, in the case of
the goods, rights and obligations of the company at the reference
date?
72. Is it correct to say that the value of the shares is the value of
the results capitalization which, according to the Institute of
Accounting and Auditing (ICAC) represents the sum of the expected
future results of the company during a certain period, discounted
at the moment of the valuation?
73. Is it true that a company creates value for its shareholders
during a year if it distributes dividends or if the quotation
of the shares increases?
74. The ROE (Return on Equity) is the ratio between net income and
Shareholders equity. The meaning of ROE is return to shareholders.
of
the
return
to
88. An investment bank affirms that the VTS (Value of Tax Shields) of
my company is equal to each years VTS using the WACC as a discount
rate. I told them that I have never seen such a calculation of the
VTS but they answered that it was a habitual practice. Is that
true?
89. I have two valuations of the company we set as an objective. In
one of them, the
present value of tax shields (D Kd T) was
calculated using Ku (required return to unlevered equity) and, in
the other one, using Kd (required return to debt). The second
valuation is a lot higher than the first one, but which of the two
is better?
90. My investment bank told me that the beta provided by Bloomberg
incorporates the illiquidity risk and the small cap premium
because Bloomberg does the so-called Bloomberg adjustment formula. Is
that true?
91. As my company is not listed, the investment banks apply an
illiquidity premium. Actually, they say it is an illiquidity
premium but then they call it a small cap premium. One of the
banks, apparently based on Titman y Martin (2007), added the
following
small cap premiums: 0.91 if the capitalization is
situated between $1,167 and $4,794 million; 1.70 if the
capitalization is between $331 and $1,167 million; 4.01 if it is
lower than $331 million. Another bank adds 2 because
historically the return of small companies was smaller than that of
big companies. Which one is more appropriate?
92. Which taxes do I have to use when calculating the Free Cash Flow
(FCF) is it the marginal tax rate or the medium tax rate of the
leveraged company?
93. According to what I read in a book, market efficiency hypothesis
implies that the expected average value of variations in the
shares price is zero. Therefore, the best estimate of the future
price of a share is its price today, as it incorporates all the
available information. Is that right?
94. An investment bank calculated my WACC.
definition of the WACC is WACC = RF + u (RM
free rate, u the unleveraged beta and RM
This is different from what we have seen
right?
nor
valid
for
any
Fernndez, P. (2004a), "Cash Flow is a Fact. Net Income is Just an Opinion." It can be downloaded
from: http://ssrn.com/abstract=330540. Fernndez, P. (2004b), Valoracin de Empresas. 3rd
edition, Gestin 2000.
8 - IESE Business School-University of Navarra
Calculated beta
Figure 1
1,8
1,8
BetaIBEX
IBEXdaily
dailydata
data
Beta
SAN
SAN
BetaIBEXmonthly
IBEXmonthly data
data
Beta
1,6
1,6
ta
e 1,4
b
1,4
1,2
ed 1,2
lculat
1
a 0,8
C
0,8
0,6
Calculated beta
Beta
EuroStoxx50daily
50daily data
data
Beta
EuroStoxx
30-Dec
30-Dec
SAN
SAN
Beta
Euro
Stoxx50monthly
50monthly data
Beta
Euro
Stoxx
data
1
0
-
3
0
-
7
0
-
31-Dec-07
30-Dec
30-Dec
6
0
-
30-Dec-06
30-Dec
30-Dec
5
0
-
30-Dec-05
4
0
-
30-Dec-04
3
0
-
31-Dec-03
2
0
-
30-Dec-02
31-Dec
31-Dec
1
0
-
30-Dec-01
0
0
-
30-Dec-00
30-Dec
30-Dec
9
9
-
31-Dec-99
8
9
-
30-Dec-98
30-Dec
30-Dec
7
9
-
30-Dec-97
6
9
-
30-Dec-96
30-Dec
30-Dec
5
9
-
31-Dec-95
4
9
-
30-Dec-94
31-Dec
31-Dec
3
9
-
30-Dec-93
2
9
-
30-Dec-92
31-Dec-91
0,4
0,6 1
9
0,4
1,8
1,8
1,6
1,6
1,4
ta
e
1,2
1,4
b
1
ed 0,8
1,2
1
0,6
lculat0,4
a
30-Dec
30-Dec
7
0
-
31-Dec-07
6
0
-
30-Dec-06
30-Dec
30-Dec
5
0
-
30-Dec-05
30-Dec
30-Dec
4
0
-
30-Dec-04
31-Dec
31-Dec
2
0
-
31-Dec-03
0
0
-
30-Dec-02
30-Dec
30-Dec
9
9
-
30-Dec-00
8
9
-
31-Dec-99
30-Dec
30-Dec
7
9
-
30-Dec-98
6
9
-
30-Dec-97
30-Dec
30-Dec
5
9
-
30-Dec-96
4
9
-
31-Dec-95
31-Dec
31-Dec
3
9
-
30-Dec-94
2
9
-
30-Dec-93
1
9
-
31-Dec-91
0,4
30-Dec-01
0,8
0,6
30-Dec-92
A18. There are three easy moves to make money when prices are going down:
credit sale, futures sale and purchase of put options. Credit sale of a
share implies borrowing it and sell it afterwards. For example, we sell
the share today at a certain price (we can say 10) but we owe a share to
the institution that lent it to us. If the quotation of the share goes
down to 8 Euros
the following week, we buy the share and give it back
to the institution that borrowed it to us and cancel out our position. In
this case, we will have earned 2 Euros (the 10 Euros we earned from the
sale of the share minus the 8 Euros we paid to buy it). Meanwhile, of
course, we will owe a share to the institution that lent it to us and
they will ask for some guarantee to cover
the debt. Futures sale is
very similar to credit sale but with the advantage that, normally, the
guarantees demanded are lower. For example, an investor who sold a
futures contract on the IBEX 35 on Friday 18 th of January, when this was
at 13,900 points, and closed his position (by buying a futures contract
identical to the one he sold) on Monday 21 st, when it was at 12,700, would
have earned 12,000 Euros. The calculation is a lot easier: 10 Euros for a
point. The price fell by 1,200 points and, therefore, the investor gained
12,000. But if the IBEX 36 had gone up, the investor would have lost 10
Euros for each point.
A19. The reasonable one according to the business risk of the subsidiary.
A20. Seasonal businesses can be valued by discounting flows using annual
data, but this requires some adjustments. The correct way to value the
flows is using monthly data. Fernndez (2003 and 2004, chap. 30) 2 shows
that errors due to the utilization of annual data are important. When
using annual data, the calculations of the value of the unlevered company
and of the value of tax shields have to be adjusted. On the other hand,
the debt we have to subtract in order to calculate the value of the
shares does not need any adjustment. Using the average debt and the
average of the working capital requirements does not provide a good
approximation of the value of the company. There is not much emphasis on
the impact of seasonality in company valuation: Damodaran (1994), Brealey
and Myers (2000), Penman (2001) and Copeland (2000) do not even include
the terms seasonal or seasonality in their indexes.
A21. No. Different methods of valuation by discounting flows always
provide the same value (if done correctly). Fernndez (2006 and 2004,
chap. 28)3 shows that 10 methods of valuation by
the method of flows
discount always provide the same value. This result is logical as all the
methods analyze the same reality under the same hypothesis; they differ
just in the cash flows they use as a starting point in the valuation.
A22. The EVA (Economic Value Added) is the profit before interests minus
the book value of the company multiplied by the WACC. The EP (Economic
Profit) is the net income minus the book value of the shares multiplied
by the required return to equity. The CVA (Cash Value Added) is the
profit before interests plus depreciation, minus economic depreciation,
minus the cost of the used resources. Fernndez (2001) 4 shows that EP, EVA
and CVA do not measure value creation in a company for each period. These
parameters can prove to be of certain usefulness to executives and to the
business units when setting objectives, but it does not make any sense to
give the EP, EVA and CVA the significance of value creation for each
period.
A23. If someone knew how to forecast exchange rates, they would be a
millionaire and would not lose time on forecasting exchange differences!
There is no formula that could forecast exchange rates reasonably well.
Actually, supposing a constant exchange rate leads to bad forecasts, but
is still better than supposing the exchange rate would follow the
inflation differential or the interest rates differential.
A24. Theoretically, the WACC can only be constant if a constant debt is
expected. If the debt changes from one year to the next, the WACC changes
as well. In order to value companies in which debt changes dramatically,
the APV (Adjusted Present Value) is easier and more intuitive. It is
possible to use a constant WACC (the weighted average of the WACC of the
different years) when debt changes, but it is a number that does not have
anything to do with the WACC in a particular year.
Fernndez, P. (2003), "How to Value a Seasonal Company Discounting Cash Flows." It can
be downloaded from http://ssrn.com/abstract=406220. Fernndez, P. (2004), Valoracin de
Empresas. 3rd edition, Gestin 2000.
3
Fernndez, P. (2006), "Valuing Companies By Cash Flow Discounting: Ten Methods and Nine
Theories." It can be dowmloaded from: http://ssrn.com/abstract=256987. Fernndez, P.
(2004), Valoracin de Empresas. 3rd edition, Gestin 2000.
4
Fernndez, P. (2001), "EVA and Cash Value Added Do Not Measure Shareholder Value
Creation." It can be downloaded on http://ssrn.com/abstract=270799
IESE Business School-University of
Navarra - 11
Fernndez, P. (2007), Valuing companies by cash flow discounting: Ten methods and nine
theories, Managerial Finance, Vol. 33, No 11, pp. 853-876. It can be downloaded from:
http://ssrn.com/abstract=256987
6
Fernndez, P. (2002), Valuation Methods and Shareholder Value Creation, Academic Press,
San Diego, CA. Fernndez, P. (2004), Valoracin de Empresas, 3rd edition, Gestin 2000.
7
The EVA is not a new concept. In 1924, Donaldson Brown, financial executive of General
Motors, had already said: the objective of the executives is not maximizing investments
but achieving an incremental profit superior to the cost of the resources used.
8
That is why a valuation is a repetitive process: the free cash flows are discounted at the
WACC in order to calculate the value of the company (D+E), but in order to obtain the WACC
we need the value of the company, (D+E).
10
When this does not happen, the equation of the WACC appears at:
http://ssrn.com/abstract=256987
11
These results come from Fernndez, P. and V. J. Bermejo (2008), Rentabilidad de los
Fondos de Inversin en Espaa. 1991-2007. It can be downloaded from:
http://ssrn.com/abstract=1095303
12
Refer to, for example, Fernndez, P. and J. M. Carabias (2006) "La Prima de Riesgo." It
can be downloaded from http://ssrn.com/abstract=897676
13
Refer to, for example, Fernndez, P. (2001), "A Definition of Shareholder Value
Creation." It can be downloaded from: http://ssrn.com/abstract=268129
A37. No. Sustainable growth it is just a number that shows how much a
company could grow without any capital increases or debt increases and
considering a constant return. On the other hand, an increase in sales or
net income depends on the market and on the competition and has little to
do with sustainable growth.
A38. No. The return to dividends and the relation between capitalization
and the book value of shares are better indicators, on average.
A39. There is no optimal capital structure. Capital structure is a
variable which depends on the inclination of high directives and which
has a lot of implications for the company: for its daily functioning, for
its growth, for its capacity to manage risks and crisis and for its
survival. If we consider the optimal structure the one that produces a
minimum WACC, then the optimal structure is the one that maximizes debt.14
A40. Debt has no influence on Free Cash Flow because this is, by
definition, the flow to shares if the company had no debt. However, the
equity flow does depend on the debt. This also
affects the
capitalization and the value of shares. If a company increases its debt,
its capitalization decreases and, naturally, the price per share
increases.
A41. No.
A42. By buying and selling their own shares some companies try to soften
oscillations in the share prices.
A43. A 4 x 1 Split is an operation by which a shareholder now owns 4
shares for each share he/she had before. Logically, the stock market
value of each of these new shares is of their value before the split.
Why is it useful? One of the possible answers is that it reduces the
price of a share in order to increase liquidity.
A44. The answer to both questions is no. See A13, A16, and A17.
A45. No. The capital cash flow is the flow available to all holders of
securities of the company (debt and shares) and it represents the sum of
the cash flow available to shares (CFac) and of
the cash flow that
belongs to debt holders (CFd). The expression which relates CCF with FCF
is the following: CCFt = FCFt + Dt-1 rt T
A46. No. In Fernndez (2006) 15 we arrive at this conclusion after
analyzing more than 100
books and financial articles. The following
chart and table illustrate this point:
14
The reader can refer to Fernndez, P. (2001), "Optimal Capital Structure: Problems with the
Harvard and Damodaran Approaches." It can be downloaded from:
http://ssrn.com/abstract=270833
15
Fernndez, P. (2006), "The Equity Premium in Finance and Valuation Textbooks. It can be downloaded
from: http://ssrn.com/abstract=934324
14 - IESE Business School-University of Navarra
Figure 2
Risk premium recommended in some books and papers
Assumption
REP recommended
REP used
1926-81
8.3%
8.3%
1926-85
8.4%
8.4%
1926-88
8.4%
8.4%
8.2 - 8.5%
No official position
6.0 - 8.5%
No official position
5.0 - 8.5%
8.0%
1926-88
5 - 6%
6%
1926-92
5 - 6%
5.5%
1926-98
4.5 - 5%
5%
1903-2002
3.5 4.5%
4.8%
1926-88
8.5%
8.5%
1926-93
8.5%
8.5%
1926-94
8.5%
8.5%
1926-97
9.2%
9.2%
1926-99
9.5%
9.5%
1926-02
8.4%
8%
6.0%
3 - 7%
5.0%
10%
10%
5%
REP=EEP
6.5%
6.5%
7.75%
7.75%
6.5%
6.5%
st
1926-2001
1926-90
5%; 8%
5.5%
5.5%
5.5%
5.5%
2001a
average IEP
1970-2000
4%
4%
2002
1928-00
5.51%
5.51%
1928-2004
4.84%
4%
nd
5-6%
7.5%
8%
1926-00
5.7%
1926-99
Pratt (2002)
REP=EEP=HEP
Fernndez (2002)
Penman (2003)
Bruner (2004)
1926-2000
6%
1926-2000
7.3%
7%
Arzac (2005)
REP=IEP
5.08%
5.08%
6.2%
7.4%, 8%
6%
4%
REP = required equity premium; HEP = historical equity premium; IEP = implied equity
premium; EEP = Expected equity premium
5.7%
6%
(based
is the
In the
g. We
cannot
A57. The g that affects the PER is not ROE (1-p)/[1 ROE (1p)], but the
expected average growth of the profit per share, which is not observable.
A58. Basically, you should use the discount of expected flows. After
doing the valuation you can calculate some ratios and compare them with
other companies from the sector to see if they make sense.
A59. 1st Perform forecasts of Balance Sheets and Profit and Loss Accounts
for the following fiscal years; 2 nd calculate the flows to shareholders;
3rd discount them at the present date (with
a discount factor); 4 th add
th
terminal value to it, and 5 add the value of assets which do not affect
the business (they can be sold without affecting in any way the flows
calculated so far). There is no need to consider the difference between
the book net value and the market value of intangibles.
A60. It is an operation by which you get three new shares for each of the
shares you used to possess. Logically, the stock market value of each of
these new shares is 1/3 of the value they had before the split.
A61. In order to value the butchers as a business you should also
forecast the flows it will provide. As the butchers does not seem to be a
business with a high rate of growth, you can consider how much the owner
earned for all the concepts, during the past years (and the increases in
the cash holdings, if any). From this quantity you should subtract a
reasonable
wage and the difference you obtain is the flow for the
shareholder. However, this is just for the case where this type of
valuation results superior to the liquidation value (if the local or the
leasehold assignment were very valuable).
A62. It depends on how the oil will affect the collections and payments
of the company (its expected flows). However, the expectations on the
future price of oil are far more important than its price today.
A63. This is the job of an auditor: they can make use of experience,
asking the reasons behind the numbers and judging whether these respect
accountancy norms.
A64. It is not always true that if this ratio is positive then it is more
profitable to invest in equity. How much confidence can an investor have
in this ratio? It is not an
investment criterion; nor is any other
ratio.
A65. The document you refer to is the report of an investment analyst.
The analysts, as are all individuals concerned with predicting the
future, are usually wrong 50 of the time. The
value of an analysts
report is not in their recommendations (if the future were clear to
them, they would not need to work as an analyst), but for their analysis
of the company and competition.
A66. During 2005-2008, the market value of the shares of listed Spanish
companies was more than triple their book value. The same thing happened
with the stock markets in all occidental countries, where less than 1 of
the companies had a higher book value than their market value.
A67. Goodwill is just the difference between the price paid and the book
value. Its dimension is due to more than just brand value: value added of
land and real assets,
the
value
of
a motivated organization,
corporative culture, distribution channels There are also situations,
especially with high interest rates, where the price of the shares is
lower than their book value; does this mean the value of the brand is
negative?
A68. Yes. The value of the shares of a company represents the present
value of the expected equity flows. Today, the expected (future) equity
flows are intangibles. Consequently, the value
of the shares is intangible (we cannot say the same thing about their
price). Affirming that there is only a part of their present value which
is intangible is a mistake.
A69. Neither book values nor market values are used. The values which
have to be used are those resulting from the valuation.
A70. The market risk premium (required return) is not the difference
between the historical return of the stock market and that of fixedincome. For example, the historical return of the stock market over
fixed-income in the United States fluctuates between 3
and 15
according
to the time period referenced. The required equity premium is
the additional return an investor requires of the shares above the riskfree fixed-income. It does not have the same value for
each investor
and it is not observable. Therefore, we cannot say it is a characteristic
parameter of the national or international economy.
A71. The method denominated value of the real net assets has no
theoretical base (and no good sense): it is a mixture of the book value
and the market value of assets. Nor is it a liquidation value.
A72. The method denominated value of the results capitalization has no
theoretical base (and no common sense).
A73. No. A company creates value to shareholders if the return they get
is higher than the required return. In order to create value, it is
necessary that the return on dividends plus the return due to price
increases be superior to the required return; it is not enough if it is a
positive number.16
A74. If ROE was a good proxy for the return to shareholders of unlisted
companies, it should also be a good proxy for listed companies. However,
the ROE of a particular year does not have much to do with the return to
shareholders that particular year.17
A75. The WACC is neither an opportunity cost, nor an expected return,
nor an average historical return. The WACC is a weighted average of
required returns.
A76. This affirmation is an error. The relation between the value of the
shares of different years is: Et = Et-1 (1+Ket) CFact. The value of the
shares is constant (Et = Et-1) only if CFact = Et-1 Ket. This happens in nongrowing perpetuities.
A77. No. The reasonable thing to do is to finance the permanent
requirements of financing (either due to current assets or fixed assets)
with long-term debt and the temporary requirements of financing with
short-term debt.
A78. No. The risk premium is the return differential (above the return
that can be obtained by investing in government bonds) that an investor
requires for stock market investment. It is not
a characteristic
parameter of an economy as each has his own risk premium. The value of
the
16
See, for example, Fernndez, P. (2001), "A Definition of Shareholder Value Creation." It
can be downloaded from: http://ssrn.com/abstract=268129
17
This is shown, for instance, in Fernndez, P. and V. J. Bermejo (2008) "Bancos espaoles
1991-2007. Rentabilidad y creacin de valor. It can be downloaded from:
http://ssrn.com/abstract=1092395
verify
the
Table 1
3 Years
5 Years
10 Years
16 Years
24.5%
25.9%
13.7%
16.4%
22.5%
24.1%
10.4%
15.1%
40.9%
36.5%
30.6%
30.8%
31.1%
30.5%
28.4%
28.2%
29.7%
30.4%
26.4%
27.5%
18
3 Years
5 Years
10 Years
16 Years
24.5%
25.9%
13.7%
16.4%
22.5%
24.1%
10.4%
15.1%
26.3%
28.8%
20.6%
22.3%
26.4%
26.0%
19.4%
22.0%
27.0%
26.3%
20.5%
22.6%
If can also be verified that the index IBEX Top Dividend had
a return of 269.61 between December 1999 and December 2007 while the
IBEX 35 had a return of 30.42 . The return on the IBEX Top Dividend was
higher than the IBEX all of these years except for 2007.
A86. Obviously not. The required return to shares (7.26 ) is a
ridiculous number for an entertainment center. On the use of calculated
betas, see questions 16 and 17.
A89. Fernndez (2001)21 shows that discounting the tax shields with the Ku
and the WACC is not correct. There are six habitual expressions to
calculate the value of tax shields which are frequently used. Only three
of them are valid (they have a theoretical basis): Myers (1974) and
Modigliani-Miller (1963), when the company plans to return the existing
debt without making a new one; Miles-Ezzell (1980) when the company plans
its debt proportionally to the market value of the shares; and Fernndez
(2004), when the company plans its debt proportionally to the book value
of the shares or assets.
Fernndez (2004): VTS = VA[D Ku T; Ku]. Miles-Ezzell (1980): VA[Ku; D T Kd]
(1+Ku)/ (1+Kd) Myers (1974) and Modigliani-Miller (1963): VTS = VA[Kd; D T Kd]
Other incorrect formulae to calculate the value of tax shields are:
Damodaran (1994): VA[Ku; DTKu D (Kd RF) (1T)]; Practitioners: VA[Ku; DTKd
D(Kd RF)] Harris-Pringle (1985) y Ruback (1995, 2002): VA[Ku; D T Kd]
20
adding 0.33 to it. Adj. Beta = 0.67 x raw beta + 0.33. It is important to
point out that this adjustment is completely arbitrary.
A91. It is obvious that the size is not always a source of risk: there
are, in all sectors, small companies with lower risks than bigger ones.
On the other hand, it does not seem that illiquidity affects the value
when the shares of an unlisted company have a certain buyer, either
because it is stated in the bylaws of the company, or because a
shareholder wants to convert his/her debt into shares
A92. The correct taxes are the hypothetical ones the company would pay if
it had no debt.
A93. The relationship between the expected value of the shares (Et) for
different years is: Et = Et-1 (1+Ket) CFact. Et = Et-1 only if CFact = Et-1
Ket. This only happens in non-growing perpetuities.
A94. No. This formula is not the definition of the WACC but of the
required return to the shares of the unlevered company (Ku).
A95. It is a mystery to which economic doctrine the Supreme Court
refers to in its sentence. The methods referred to lack any basis.
A96. It is true. After placing the shares of Vueling at 30/share
in December 2006 and at
31/share in June 2007, the 2nd of October of 2007, the investment bank
set the objective price at 2.5/share.
st
1 December of 2006. IPO of Vueling at 30/ share. The first day, the closing price was 32.99/share.
23 February of 2007. Maximum at 46.7/share.
th
6 June of 2007. Placement of the 20.97% of the share capital of Vueling (shares of Apax) at 31/share.
th
19 July of 2007. One of the placement banks recommends selling at the objective price at 20/share.
August 2007. Vueling admits not being able to fulfill the business plan: the shares fall in 30%.
st
3 October of 2007. The same placement bank values Vueling at 2.5/share. Quotation: 8/share.
rd
23 October of 2007. The bank increases the value of a share from 2.5 at 13, and it still recommends to 'sell.'
th
28 December of 2007. The last quotation of 2007 is the value of the share from 8.95/share.
22